As the current administration nears its first 100 days in office, legislation and immediate priorities have remained centered on containing the COVID-19 pandemic and strengthening the economy following the passage of the American Rescue Plan. However, discussions are already underway in Congress about possible changes to the current tax law that may impact income, corporations and estate planning for high-net-worth individuals. Enacting sweeping changes to the tax code is likely to take some time, but it’s wise for taxpayers looking to transfer assets to future generations to engage in thoughtful and proactive planning now to mitigate risk and maximize their investments.
In the current political landscape, proposed changes that could potentially affect estate planning include a reduction in the tax exclusion amount allowed for gift and estate taxes, increases to both the capital gains and estate tax rates, and elimination of the step-up cost basis at death.
Under current law, the federal estate tax exemption is $11.7 million for individuals and $23.4 million for couples. The current administration and members of Congress are exploring lowering that exemption to a range between $3.5 million to $5 million for individual earners. Progressive estate tax rate increases could range anywhere from 45% to 65% depending on the total value of the estate, and the capital gains tax could double from 20% to 40% for taxpayers in the top income tax bracket.
Elimination of the step-up cost basis would significantly alter how property is valued when passed on after death. Rather than “stepping up” the cost basis of an inherited property without owing any capital gains taxes, the change could result in tax increases for those inheriting property that has risen significantly in value over time.
While the question of whether these changes will be made retroactively remains up in the air, there are a few possible solutions and planning strategies to explore that take advantage of current exclusion amount and can reduce a potential long-term tax burden.
Use your estate exemption now
A Spousal Lifetime Access Trust (SLAT) is one estate planning strategy that can be used for transferring wealth outside of an estate and protecting the transfer of assets to future generations. A SLAT allows a grantor or donor to make a gift into a trust to benefit a spouse or another elected family member in the form of large, permanent gifts that reduce the size of the grantor’s estate. For example, for a married couple, a SLAT may allow you to take advantage of the federal lifetime gift and estate tax exclusion while retaining limited access to the assets.
Among its many advantages, SLATs allow you take advantage of current federal tax exclusion now before changes are enacted. Because a SLAT is considered a taxable gift, if structured properly, the grantor or donor pays the taxes at the current tax rate and any appreciation of those assets stays within the trust before the law changes. By using the exemption before it’s gone, donors will only have to pay income tax on the earnings generated in the trust rather than shouldering estate tax on the assets at a possibly higher rate, which poses a future tax advantage.
Reduce your taxable estate
Instead of using an exemption, another favorable option to explore in a rising tax environment is to reduce the size of your estate through the removal of assets by using a charitable remainder unitrust, or “CRUT” as it is commonly called. A CRUT is another type of irrevocable trust that generates a potential income stream for donors or other beneficiaries, with the majority of the donated assets going to one or more public or private charities. This split-interest trust is ideal for donors with charitable or philanthropic inclinations and serves several purposes.
One advantage to forming a CRUT is that it allows the donor to make a partially tax-deductible donation. After funding the trust with assets such as real estate, stocks, mutual funds, or ETFs, the partial income tax deduction will be determined based on the term of the trust, projected income payments and current IRS interest rates. In simpler terms, when you have money flowing into a trust and that money then goes to a charity, you receive a charitable deduction at the current rate, which allows you to leverage your assets and seize current low tax rates simultaneously.
Using low-basis stock for a CRUT will provide additional benefits to donors if changes are made to the capital gains rate or the step-up cost basis at death is eliminated at the federal level. By contributing low-basis stock to a CRUT, you wouldn’t pay tax on the gain. Essentially, it can be viewed as a tax elimination strategy, allowing you to leave other assets to loved ones with higher basis.
In terms of future tax advantages, upon the termination of the CRUT or following the death of the last income beneficiary, the remaining assets are then distributed to the designated charities and will not be included in the estate, eliminating the potential for an estate tax.
Combine both strategies
For some individuals, it may be wise to consider a combination of these strategies, versus selecting one over the other, as they each have advantages and disadvantages to take into consideration. Evaluating the benefits and potential drawbacks of these trusts is essential to devising a plan that will protect your assets and your estate long-term.
Even if current proposals or changes to the tax law stall for a period of time, enacting these strategies now can shield you from future risk, as any gains in either a SLAT or CRUT are considered outside of the estate for taxation purposes. To determine the estate planning strategy that’s right for you, consult with trusted professionals before taking action to ensure your strategies align with your goals. Working with a team of attorneys, CPAs, investment professionals, and corporate trustees will assist you in providing a comprehensive estate plan. Acting now will benefit you today and well into the future.
Susan Herendeen is division manager for ESL Trust Services. Throughout her career in financial services, she has focused on the areas of personal financial planning, including estate and trust planning, investment management and nonprofit organizations. Serving as planning manager and wealth advisor prior to joining ESL Trust Services, Herendeen brings more than 22 years of experience in the financial services industry. Working with a team of ESL Trust Services specialists, she provides strategies and tools to help clients and organizations reach their estate planning and financial goals. She holds several industry certifications, including Certified Financial Planner, Certified Trust and Fiduciary Advisor and Accredited Estate Planner.